Two of the largest financial changes affecting the real estate industry as part of the Tax Cuts and Jobs Act in the US are the new interest expense limitation and changes to depreciation for real estate assets and related assets. It is important for taxpayers and practitioners alike to understand the impact and plan for 2018.
As has been widely publicized, the Act requires businesses to limit their interest expense to an amount not to exceed 30% of their adjusted taxable income. However, at a taxpayer’s election, a taxpayer in a real estate trade or business may avoid this interest expense limitation. Real estate trades or businesses are generally businesses that acquire, develop, redevelop, lease or own real property.
In exchange for the ability to fully deduct their interest expense, the Act requires that any real property trade or business that makes this election utilize the alternative depreciation system for their assets. The ADS system generally requires straight-lined depreciation methods over longer useful lives than those available under MACRS.
Prior to passage of the Act, the Senate proposal provided for much shorter depreciable lives for real property assets. Unfortunately for the real estate industry, the new law does not provide for any shorter lives and maintains the original depreciable lives. The new law does provide for an expansion of bonus depreciation, allowing for 100% expensing of eligible assets placed in service after September 27, 2017, and before January 1, 2023. In order to qualify for 100% expensing, assets should have a depreciable life shorter than 20 years. Any taxpayer who takes advantage of the election out of the interest expense limitation and is therefore required to use ADS, will not be able to use 100% expensing.
In addition, the Act streamlines the definition of qualified improvement property. Prior to the Act, there were four separate definitions for qualified leasehold improvement property, qualified retail improvement property, qualified restaurant improvement property, and qualified improvement property. Under the Act, only qualified improvement property remains and applies to improvements made to the interior of non-residential real property. Interestingly enough, the new Act did intend for these qualified improvement property assets to be depreciable over 15 years and to qualify for 100% expensing, however, there needs to be a few technical corrections made to the Act in order for that to actually apply.
Finally, prior to the Act, all real estate under ADS was depreciable over 40 years. The new law shortens the ADS life for residential real property to 30 years. It also intended to shorten the ADS life for qualified improvement property to 20 years, however technical corrections to the legislation will need to be enacted in order for that to take place. These shorter ADS lives will be very important for taxpayers who elect out of the interest expense limitation.
Author: Brian Lovett, CPA, JD - Tax Partner and Real Estate Tax Team Leader at WithumSmith+Brown, PC